Fool.com: Roth IRA - Part IV
Roth IRA, Part IV
Penalty Issues

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By Roy Lewis

Having already discussed contributions, conversions, and distributions, let's now look at the penalty issues regarding "early" distributions from a Roth IRA.

Penalties on Earnings from Contributions

Unless an exception applies, most distributions from a Roth IRA before the owner reaches age 59 1/2 will be subject to an "early withdrawal penalty" of 10% of the amount of the distribution. Be very careful not to confuse the "early withdrawal penalty" with the taxes imposed on a non-qualified distribution -- two separate things. Non-qualified distributions carry a tax on the earnings portion of the distribution, and an early withdrawal penalty in addition to the tax. Ouch.

Example #1: Jim, age 30, makes a Roth IRA contribution of $2,000 in 1998. In year 2005, Jim's Roth IRA has a balance of $3,500 ($2,000 in initial contributions and $1,500 in earnings). Jim decides to close his Roth IRA in a non-qualified distribution in year 2005. Since the distribution is non-qualified, Jim will owe taxes on his Roth earnings of $1,500, and will pay tax on this amount at his normal tax rate.

In addition, since the distribution took place before Jim reached age 59 1/2, and since he did not meet any of the exceptions, Jim will also be assessed a 10% early withdrawal penalty on the $1,500 in earnings. If we assume that Jim is in the 28% marginal tax bracket, he will pay $420 in income tax on the earnings, and will also pay a penalty of $150 (10% of $1,500) on the early distribution. This could be a very steep price to pay -- especially compared to the tax-free status of qualified distributions.

Exceptions

The 10% early withdrawal penalty does not apply to the following distributions:
  1. To a beneficiary because of the death of the Roth IRA owner.

  2. Due to the IRS-defined disability of the Roth IRA holder. (This can be a very narrow definition, so if you get a severe paper cut, don't consider a Roth IRA distribution until you review IRS Code Section 72(m)(7) and IRS Publication 590.)

  3. That are part of a series of substantially equal periodic payments made at least annually for the life (or life expectancy) of the Roth IRA owner or the joint life (or expectancies) of the Roth IRA owner and the beneficiary. Again, this exception can get pretty complicated, so if it's something that piques your interest, make sure to read more about this exception in IRS Publication 590.

  4. To the extent that the distributions do not exceed the amount allowable as an itemized medical deduction (regardless of whether you itemize your deductions).

  5. To certain unemployed individuals for payment of health insurance premiums.

  6. To pay higher-education expenses.

  7. To pay for qualified first-time homebuyer expenses.

  8. For distributions after December 31, 1999, to pay a levy on the IRA under Code Section 6331. This won't apply to most of you (hopefully). But, if you are in hot water with the IRS collection folks, it's something that you might want to be aware of.
As you will note, these are similar to the penalty exceptions that apply to a regular IRA. For an additional discussion of these penalty exceptions, read IRS Publication 590.

Penalties on Conversions from a Regular IRA to a Roth IRA

The penalty rules regarding conversions are a bit different from the ones for contributions. Remember that, with contributions, you can withdraw your "principal" contributions at any time, and those withdrawals are not subject to taxes or penalties (as noted in the example for Jim above, and as discussed in the Roth IRA Part III article).

However, an early distribution from a prior traditional-to-Roth IRA conversion has a different twist. The early withdrawal penalty applies to a distribution from a prior conversion, but:
  1. Only if the distribution is made within the five-tax-year period starting with the year that the conversion was distributed from the traditional IRA; and

  2. Only to the extent that the distribution is includable in gross income as a result of the prior conversion.
Example #2: Paul makes a $20,000 conversion from his regular IRA to a Roth IRA in 1999. The entire amount converted is includable in Paul's income for 1999. Paul makes no additional contributions or conversions in later years. In 2002, before he is age 59 1/2, Paul withdraws $10,000 from the Roth IRA. While Paul will have no tax to pay on this distribution, he will have to pay a 10% penalty (or $1,000) unless one of the exceptions noted above applies.

Why? Because Paul didn't keep the conversion amount in his Roth IRA for the required five-tax-year period, and this amount was required to be reported as income when Paul made his original conversion.

So, if you are going to take funds "early" from your Roth IRA, weigh your conversion decision very carefully -- especially if you made non-deductible contributions to your original IRA. If you did make non-deductible contributions to your regular IRA, you'll generally be worse off by converting to a Roth IRA and taking the funds early than you would be by simply taking the funds from the regular IRA.

Why? Because a pro rata part of all withdrawals from a regular IRA are treated as coming out of non-deductible contributions. But, amounts withdrawn from Roth IRA conversions are treated as coming out of income taken into account on the conversion first. We'll talk about that in more detail in Part V when we discuss the "ordering rules."

Not quite clear on how this works? Let's take a look at an example:

Example #3: Karin has a traditional IRA with a balance of $12,000. $6,000 of that IRA balance was from prior-year deductible contributions and total IRA earnings. The other $6,000 represents prior-year non-deductible contributions. Karin is contemplating a Roth IRA conversion, but also wants to take a distribution of $4,000. Karin's options are as follows:
  1. She can leave her money in the traditional IRA and take the $4,000 distribution. She'll be taxed on half of the distribution ($2,000) because half of the account is deductible contributions and earnings. She'll also pay a 10% penalty, but only on the $2,000 taxable distribution. The other $2,000 is tax- and penalty-free... since it came from prior non-deductible contributions to the IRA.

  2. She can convert the entire traditional IRA to a Roth IRA and then take the $4,000 distribution. This is a bad choice for Karin. Once Karin takes the $4,000 distribution, she'll be subject to a 10% penalty on the entire distribution because of the ordering rules. She won't have to pay any tax on the distribution (since the tax was paid when she converted the traditional IRA to the Roth IRA), but making this choice causes Karin to pay an additional $200 in penalties that could have been avoided with proper planning.
On the other hand, if you are reasonably young (under age 50) and expect to need to withdraw funds from your IRA in five years (and can't use any exceptions to avoid the 10% penalty), you might be better off converting funds from your regular IRA to a Roth IRA now. If you wait until after the five-tax-year period to withdraw money from a Roth IRA, the 10% penalty won't be imposed, even if you aren't yet 59 1/2 and don't meet any other exception to the penalty.

Why? Because, for a Roth IRA, you have met the five-tax-year exception on the converted funds and therefore dodge the 10% penalty on these distributions. But, there is no five-tax-year exception for a regular IRA. So, while you would still pay tax on the earnings in either case, you would escape the 10% penalty by converting to a Roth IRA. Not clear on this? Another example might be in order:

Example #4: Rick converts $30,000 from his traditional IRA to a Roth IRA in 1999. This conversion is all taxable to Rick at the time of the conversion because he had made no non-deductible contributions to his traditional IRA. He does not make any additional contributions to the Roth IRA after that.

In 2007, when Rick is still under age 59 1/2, he takes a distribution of $10,000. Is this distribution subject to tax? Nope... since the taxes were paid on these funds at the time of the conversion from the traditional IRA to the Roth IRA. Is this distribution subject to the 10% penalty? Nope again... because Rick held the conversion funds in the Roth IRA account for longer than the required five-tax-year period.

As you can see, the tax planning implications are numerous -- too numerous to mention here. Different tax and penalty rules can apply to distributions coming from contributions, conversions, or earnings.

Not only that, the rules regarding the 10% penalty on "early" (less than five tax-years) distributions relative to conversion amounts are determined for each conversion, and might not necessarily be the same five-year tax period that you use to determine if a distribution is "qualified" for income tax purposes.

And, the penalty rules are different for conversions than they are for earnings from contributions. It can be a real mess.

If your Roth IRA consists of only contributions or only conversions, these rules aren't too difficult to follow. But, if your Roth IRA consists of contributions, conversions in different years, and earnings on both, then the "qualified" distribution rules and the penalty rules can get very, VERY complex.

So, you really need to know the tax impact of your decision prior to removing any of your Roth IRA funds -- you can't just guess. Guessing could be hazardous to your wealth. Your best bet? Keep your paws off your Roth IRA account unless your distribution is qualified and you meet one of the penalty exceptions. It'll make your tax life easier to deal with.

In Part V, we cover some additional issues regarding distributions and penalties -- the IRS distribution ordering rules and the rules regarding income acceleration for certain 1998 conversions -- where things will get even more complicated.
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